Endogenous social discount rate, proportional carbon tax, and sustainability: Do we have the right to discount future generations' utility?

Abstract

This paper examines a serious issue - whether future generations of utility should be discounted. The issue is of vital importance because future generations will never have the opportunity to reveal their preference regarding the current resource allocation and yet this will ultimately affect their utility. This paper addresses with this issue in the context of the phenomenon of global warming that is crucially connected with the emission and accumulation of CO2. The analysis focuses on how the social optimum is attained under the constraint of sustainability and reveals the following relationship between the optimal policies: not discounting utility in social planning corresponds to adopting the socially optimal carbon tax rate in a decentralized economy. We also prove that the optimal carbon tax regime satisfies time consistency, indicating that policy is Pareto efficient for every generation given the sustainability constraint. In addition, it is shown that the theory can be extended to apply to an infinite horizon. Finally, the second-best proportional carbon tax rates are calculated using available data. The result astonishingly reveals that even if we apply a social discount rate of 5 per cent to annum in the planning economy, it is still equivalent to levying 32 per cent proportional carbon tax rate. Considering the actual absorption capacity of oceans concerning CO2, we can never be too prudent in discounting the utility of future generations with regard global climate change. This fact indicates the need for urgent introduction of a proportional carbon tax.